Bloomberg carried a story the other day citing Brooksley Born in dicussing the way that major derivatives trading firms are fighting the administrations efforts to govern the over the counter (OTC) derivatives markets, particularly the swaps market. Born has credibility on this issue. In 1998, as the head of the Commodity Futures Trading Commission, she fought unsuccessfully to regulate the growing swaps market. In truth, Born’s efforts were focused on regulating the interest rate swaps market which has not played any meaningful role in the present crisis. However, governance of the OTC swaps market would have eventually included both the credit default swaps and the commodity swaps that have played such a destructive role.
As the battle over establishing proper governance gets going, I’ve found an insightful article on Rick Bookstaber’s blog. Rick is a seasoned Wall Street risk management veteran and author of the prescient book, “A Demon of Our Own Design.” In his latest post, he argues that many of the industry’s arguments against regulation are (unsurprisingly) false.
What went so wrong in the OTC derivatives market? Contrary to the revisionist history being promulgated, I would argue that the initial deregulation of these markets in 2000 was well intentioned and reasonable. Interest rate swaps dominated these markets and were being used as risk reduction tools by bona fide institutional hedgers — i.e., sophisticated institutional investors who had offsetting real positions in traditional securities. Over the last few years, however, certain derivatives instrument were used in ways never imagined a decade ago, and these markets became dominated by speculators — those taking on risk in what is essentially a “bet,” whether on a company’s credit quality, on the price of food or energy, or other metrics. In another post, Bookstaber lays out some of the new applications for these instruments:
They are used to: avoid taxes (for example, total return swaps are used to take positions in UK stocks in order to avoid transactions-based taxes); take exposures that are not permitted in a particular investment charter (for example, index amortizing swaps were used by insurance companies to take mortgage risk); speculate (for example, the main use of CDSs is to allow traders to take short positions on corporate bonds); lever beyond an allowed level; and take risk off-balance sheet, where it is not as readily observed and monitored.
All this allowed for an explosion of this marketplace. The problem with all this massive expansion is that these are not traditional investment markets, but rather contract markets, akin to the futures exchanges. And just like the futures markets, the OTC derivatives market would benefit from some of the tried and true governance of those markets: a clearinghouse structure, margin requirement to ensure contract performance, and, for underlying markets with limited liquidity, speculative position limits to ensure that these side bets don’t end up distorting underlying prices.
The regulatory battle will be hard fought. These are complex issues where most (but not all!) of the knowledgeable players work for firms that are making a lot of money from these transactions, no matter the risks they pose to the economy in aggregate. The credit default swap mess is contained for now by the general industry disarray. However, given continued indications that commodity inflation is resurfacing, I believe we may well see the commodity problems of last year return, and potentially with greater magnitude. The only way to prevent more damage is with appropriate market governance. The administration has taken a good first stab at this issue; let’s hope that Congress can follow through.